The road to higher interest rates is painful, but should ultimately work in favor of bond investors in the long run, says asset manager Capital Group in its expectations for the second half of the year.
The US Federal Reserve (Fed) raised its key interest rate by 75 basis points to 1.50% -1.75% in June, the largest increase since 1994. In their forecast, Fed executives expect the Fed funds rate to be even higher this year. a bandwidth between 3.25% and 3.50%.
US bonds have fallen more than 10% so far this year, but there are signs that the worst is over. “The stock market volatility is likely to continue, but bond markets are unlikely to fall another 10% from now on,” said Capital Group’s portfolio manager Ritchie Tuazon.
The downward selling pressure has brought the valuation of most bonds more in line with expectations, he said. In addition, high-quality bonds can provide investors with the desired diversification, especially as stock volatility increases.
“Bond markets are unlikely to fall another 10% from now on”
Interest rate hikes and the balance sheet reduction show that the Fed is making an effort to reduce inflation. But according to Capital Group, there is still more work to be done. The US consumer price index rose 8.6% year-on-year to May and is 1% higher than in April. Core inflation, excluding food and energy, rose 0.6% compared to the previous month.
Prices have probably peaked for goods that were in extra demand during the corona pandemic. A good example: The prices of timber have fallen by 50% since the beginning of the year. However, the prices of services and necessities, such as food, housing and energy, have risen. “One category replaces another and keeps inflation high,” Tuazon notes.
Because investors have usually taken the central banks’ most aggressive plan into account when pricing bonds, it is unlikely that future adjustments will lead to much turmoil in the bond market. Tuazon: “In the coming year, bond yields are likely to rise less sharply than in the last 12 months, when markets began to worry about high inflation.”
Bond yields have risen markedly since the lows of recent years. Yields have risen in all sectors. Over time, rising interest rates mean more income from bonds. There are still pitfalls around the corner so an active approach can help. While a recession in the U.S. is not expected immediately, credit spreads may widen as investors rate the probability higher, said portfolio manager Tara Torrens.
“In the long run, rising interest rates mean more income from bonds”
Defensive sectors, such as healthcare and food, can offer more value in this environment. Commodity companies can also provide refuge in a late cycle period. “There are always opportunities, but I have a lot of liquidity that I can bet on if we see the range I expect,” Torrens said.
Finally, emerging market debt provides opportunities, according to portfolio manager Rob Neithartook. “Several countries have raised interest rates faster than the Fed and are in good financial shape.”
Fantastic entry moment
With current bond yields, history suggests higher overall returns over the next few years. This means that investors can benefit from bonds in all fixed-rate asset classes, including high yields. “Average annual returns for US high interest rates have historically been around 6% to 8%. We are finally back at a level where these returns can be achieved,” Torrens said.
Well, according to Capital Group, could now be an attractive starting point, especially for those who use bonds to encounter the volatility of stocks. “Despite all the negative headlines, there’s just a lot to be positive about,” Tuazon says.
That Editors of IEXProfs consists of several journalists. The information in this article is not intended as professional investment advice or as a recommendation to make certain investments. Editors may hold positions in one or more of the listed funds. Click here for an overview of their investments.